Government bonds sold off significantly in 2022, Felices pointed out, with seven- to 10-year bonds in the U.S. and Europe at negative 14% to 20% returns compared with mid-2021, while one- to three-year bonds saw negative 3% to 4% returns. Japanese government bond returns, however, remained relatively flat for the same period.
On the credit side, widening spreads following the Fed’s tightening moves were exacerbated by the persistent inflation shocks from supply-chain issues and impacts of the Russia-Ukraine war, Felices added. That contributed to market fears that a potential recession could be more severe than expected, but that has not materialized.
Slower growth
In recent months, economic data in the U.S. and Europe and, to some extent in Asia, has started to look more robust. “The narrative is starting to change in the sense that investor expectations of recession risk is not as imminent as it was last year,” Felices said. The PGIM Fixed Income team is in the same camp. “We are pricing in slower growth but are avoiding recession in our forecasts in the U.S. and Europe.” PGIM forecasts U.S. growth at 1% in 2023 and 0.1% in 2024, while the market consensus is 1.6% for 2023 and 0.6% for 2024. For the Eurozone, PGIM’s forecast is 0.6% for 2023 which is in line with market consensus.
The Fed is almost done with raising interest rates and the central bank will pause its rate stance after hiking one more time, according to PGIM. “In the U.S., we’re seeing positive signs: Core CPI has fallen almost two percentage points from its peak in September 2022,” Felices said. “The Fed delivered a rate hike in July this year, and we believe [it] is still on track to meet defensive objectives in terms of inflation and growth.”
Sector sensitivity
As investors parse the investment landscape, some sectors are clearly highly sensitive to interest rates, such as housing, construction and utilities in the U.S. and Europe, Felices noted. But the fear in the market was that higher rates can also have unforeseen impacts and “can lead to pressure points that have the potential to derail the recovery and escalate into something more systemic,” he said. Examples of such unforeseen impacts include the U.K. gilt crisis and the U.S. regional bank crisis, both of which caused market dislocation but didn’t escalate further.
While the market expectation that the Fed’s rapid rate increases would result in recession was warranted by prior historical models, Jiranek said the PGIM Fixed Income team explored the question: “How did the economy respond differently versus the past that has allowed us to avoid a recession?” They found two key differences in historically sensitive interest rate sectors. “First, demand was truly exceptional. A lot of these sectors are goods-focused and received a huge boost from stimulus as people looked to improve their home experiences following the pandemic. So the starting point was really strong,” he said.
“Second, while some sectors like housing and industrial equipment investment slowed as expected, others didn’t slow and actually started accelerating during the Fed’s hiking cycle,” Jiranek said. Some categories with strong demand, such as furniture, televisions and autos, were severely impacted by the supply-chain slowdown during the pandemic, with these pressures easing since about mid-2022, he noted. “What’s different [this time] is that we’ve had exceptional demand for traditionally interest rate-sensitive sectors, but we’ve also had a positive supply shock.”
Focus on quality
Given the heightened sensitivity of the fixed-income markets to macro and geopolitical risks, investors can take advantage of current higher yields and wider spreads, but they should do so selectively and with a focus on quality, Felices said. Investment-grade credit, both in the U.S. and Europe, particularly with shorter-duration exposure, offers yield with less risk versus high-yield credit, he said. In addition, securitized credit — including commercial mortgage-backed securities and collateralized loan obligations — offers selective opportunity and high-quality spreads, which have remained wide on the back of difficulties in the regional banking sector earlier this year.
When it comes to government bonds, market expectations in June that the Fed would start cutting interest rates within six months — contrary to PGIM Fixed Income’s view — actually posed risks in the event that those cuts did not materialize, Felices said. “In that environment, when considering the U.S. Treasury curve, we wanted to be underweight front-end duration. That’s one way of positioning appropriately for the risk of continued higher rates,” he said. “We favor more defensive asset classes and sectors, and shorter-duration exposure.”
Emerging market local government bonds and high-yield sovereign debt also present opportunity. “Inflation is falling rapidly, and it is doing so ahead of the developed world, with some EM central banks starting to signal that they may pause and eventually cut rates,” Felices noted. High-yield sovereign debt spreads have compressed from elevated levels. EM investment-grade spreads, however, remain at historically tight levels and have already priced in a lot of good news, he said.
Watch risks both ways
While the U.S. economy faces significant headwinds in tighter credit conditions and a weaker labor market that could lead to a shallow recession, the inflation picture is more complicated.
“When we look at the balance of risks, there are risks both ways,” Felices said. On the one hand, if there’s a U.S. recession, classic disinflationary forces will come into play with a wider output gap and lower demand. At the same time, there could be more persistent inflation than seen in the past, due to a more restricted supply of goods longer term given unsupportive U.S.-China relations, the Russia-Ukraine war and impacts from the energy transition. “The energy transition means underinvestment in hydrocarbons and more investment into green energy, but that takes time. The world still has a high demand for hydrocarbons, and with supply more likely be constrained due to underinvestment, that can be a source of inflation,” Felices said. Increased climate shocks around the globe can also continue to disrupt supply chains, which means inflation volatility is likely to be higher than normal, he said.
For the PGIM Fixed Income team, the complex interplay underscores that “there’s not only downside risk to inflation, there’s also upside risk,” and that will have a central role in how investors evaluate fixed-income opportunities as they look ahead. ■
